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by  Eric Lascelles Mar 29, 2022

In this video, Chief Economist Eric Lascelles reviews the latest developments around ongoing themes impacting the global economy. As the recent war continues to impact Russia, Ukraine and the Eurozone, he monitors how commodity shortages may also affect other regions. At the same time, rising COVID-19 infections around the world pose risks of economic damage. Finally, he addresses concerns around recession with central banks raising rates - and how this could affect inflation.

Watch time: 13 minutes 34 seconds  |   Hover your cursor over the video to see chapter options

View transcript

Hello and welcome to our latest video MacroMemo.

This week, we will talk about the war in Ukraine and some updated thinking and developments on that subject.

We’ll talk of course about the pandemic and where it seems to be going. We’ll cover China, and there’s some good and bad news on China that is worth addressing.

We’ll work our way into more general economic developments. And so, momentum is good but perhaps with some headwinds to consider going forward. We’ll visit with central banks. And so central banks have been very hawkish indeed recently.

And lastly, we’ll talk about recession risks, and specifically in the context of what the yield curve is or isn’t telling us.

Let’s start with the war in Ukraine. And so, the war continues. However, it does seem to be narrowing in scope somewhat as Russia seeks to concentrate its efforts on Eastern Ukraine and backs away to some extent from the capital city and from some of the more Central and Western areas. And so I think that can be viewed as mostly good news. Again, a narrowing of the scope of the war. Of course, equally Russia might have better prospects if it focuses its attention on a smaller area, and so perhaps mixed billing as well.

I think simultaneously we can say that discussions of negotiations continue and the possibility of a cease-fire or a peace treaty of some discussion is real. And so, there has been a convergence of views and the negotiations in Turkey. We’ve heard Turkish ministers comment that the differences are shrinking. And so it’s possible that there is a peace deal out there somewhere. In fact, one of the betting markets we track quite closely assigns a 27% chance of a peace deal before June 1st of this year. And a quite high—73%—chance of a deal before December 1st.

And so I suppose the takeaway there is that a deal is entirely possible in the next few months but far from certain. A deal is perhaps fairly likely over a longer period of time over the span of the next year.

Of course, as an economist, we care a lot about the economic damage emerging from the war in addition to the war itself. And I can say most of that comes via high commodity prices, and commodity prices still remain quite high. There’s been some movement and indeed even some retreat in certain spaces, but nevertheless still quite high commodity prices.

Food inflation is now proving, as we’d suspected, problematic for the world’s poorest countries. We’re seeing protests in quite a range of poor countries, potentially with the ability to result in regime changes.

I will say oil prices are not quite as high as they were. And so we’ve seen oil prices up into the $120 plus a barrel territory. They’re now down not much more than $100 a barrel as I record this. And so, actually that reflects less developments in Ukraine and Russia. More actually some thought that the Chinese economy might be weaker, but more on that in a moment.

In any event, the economic damage from high oil prices is maybe not set to be quite as great as feared a little while ago, though we do still think fundamentally there’s a multimillion-barrel mismatch that exists between supply and demand, and that does probably warrant triple-digit oil prices for some time.

Now beyond Ukraine and Russia, the greatest economic impact from this war is on the eurozone. It’s on the rest of Europe. And we’re starting to see some signs of economic slowdown in Europe, but I would say mostly fairly mild so far.

And it’s interesting, looking at the consensus growth forecasts out there for the eurozone, they’re still predicting 3% plus growth for the most part for 2022. We’ve penciled in 2.5%, so we’re a little bit more cautious. But maybe the big takeaway from both of those numbers is that it’s not at all a base-case scenario that Europe must descend into recession even as it grapples with these challenges.

Okay. Let’s talk about the pandemic now. And so, the broad narrative is one in which, over the past several months, there’s been quite a significant improvement as the Omicron wave has largely receded. And so that’s been very nice indeed.

I will say, though, that we’re continuing to see some evidence of another wave building. And so for instance, we can see the infection numbers now rising across a fair swath of European countries. Canadian numbers are still roughly flat, but we can see some Canadian provinces clearly rising. That includes Ontario and Quebec.

The U.S. numbers broadly look good at the national level. But again, we can see a rising number of U.S. states that are getting a little bit worse, and it happens to include all of the big ones, including California, and Texas, and Florida, and New York, and Massachusetts, and Michigan. Quite a range are now starting to deteriorate a little bit again.

And so, I guess the logic behind why we are seeing some increase in infections, some of it is this BA.2 subvariant is more contagious than Omicron. And so that’s doing some of the work. We’ve of course seen economies significantly reopen, and so that just increases the opportunity to interact with others.

And then the booster efficacy is also arguably waning. We’ve learned that these vaccines have a diminishing potency over time. And so once you’re four, and five, and six months beyond, the efficacy seems to be significantly diminished. And so a lot of countries are now bumping into that as well. And so, at this point in time, we are budgeting for another minor COVID wave. We’re not expecting a huge wave in most parts of the country. We’re not expecting major economic consequences to the extent governments are loathe to shut down again, but we probably should budget for some minor damage over the next few months.

I should say all of these comments on COVID-19, though, neglect China, which we get to next. And indeed, China is struggling very much on that front.

So let’s talk China. And so I guess really it is a yin-and-yang story, perhaps, to use the cliché. You’ve got some bad news on the COVID front. You have some good news on the policy support front. Let’s talk about the COVID side first.

And so, China is now grappling with its biggest COVID wave since the spring of 2020. And that wave continues to mount quite aggressively. Hong Kong infections are frankly quite out of control right now at an extremely high level. In fact, arguably unprecedented in the pandemic so far anywhere. We’ve seen Shenzhen lock down not long ago in China, which is a huge city. Shanghai has now been locked down, which is an indeed massive city of 26 million people. And it seems to me that it’s likely we will have to see more lockdowns as well. It seems that the genie is out of the bottle in China as it pertains to community spread of COVID-19.

And China is somewhat vulnerable to this to the extent that its population was broadly inoculated with a vaccine that seems to be less effective against the more recent, more contagious variants. China’s population has very little natural immunity because the prior waves were so small. Very few people are protected on that front. And of course, now you have this very contagious variant.

And so, it’s a tough situation for China. We don’t expect at this point in time China to abandon its zero-tolerance policy. Other countries have permitted some level of COVID to spread. China broadly has not. That policy, by the way, is popular with the public. It’s something the government has bragged about in terms of being superior to the rest of the world. And likely, China will work very hard to keep COVID as under wraps as possible, at least through the fall when President Xi will in theory get an unprecedented third five-year term.

And so, we’re budgeting for more lockdowns in China. We’re budgeting for some economic damage that emerges from that. I will say the Chinese government and businesses maybe more precisely have gotten somewhat better at handling the lockdowns in the sense that I gather factory workers are now, in some cases, sleeping in the factory. They can then continue working, even in the context of a lockdown. And so output may not be as hindered as one would first expect, but still there is some damage to the domestic Chinese economy and some limitations imposed on global supply chains, since China is a major manufacturer.

I mentioned there’s a good news side for China. This is going to be all of about 10 seconds, but it does merit some attention, which is, Chinese policymakers continue to be very supportive themselves. And so, they’re cutting interest rates, and they are beginning to ask banks to lend more to home buyers and to builders. And we are seeing plans for infrastructure investment and tax cuts and so on. And so China does want to achieve a decent 5.5% growth rate. We think they’re going to fall a little shy of that but let’s not underestimate the policy effort that exists to support the economy at this time.

Let’s talk economic trends more generally. And so, I will say that a lot of the indicators over the last few months have pointed to economic strength. It’s been a function of reopening of economies after the Omicron wave. It’s been a reflection of extremely strong and healthy labour markets. In fact, the U.S. initial jobless claims figure from last week is now the lowest since 1969. So not just pre-pandemic norms but multi-decade lows.

And we see a lot of reports, if anecdotal, from hotels, and from resorts, and these sorts of places that high-touch service activity is roaring back. People are embracing the services that they weren’t previously able to engage with. Now that’s all been very nice. We do, though, see some evidence of a bit of weakness brewing now. And so, for instance, of course, here we are dealing with central banks that are now raising rates, and a commodity shock as discussed. And so we’ve seen news sentiment turn in a more negative direction, which can limit economic growth.

We see financial conditions turning somewhat more negative as well. And so that is to say interest rates have gone up, and credit spreads have widened, and the stock market isn’t as strong as it was several months ago. And as a result, you’d expect a bit less economic growth from that.

Though I should emphasize the financial conditions, the extent of the tightening, looks more like a mid-cycle correction amount. It looks a lot like 2015–2016, not so much like the start of the pandemic. Not so much like the financial crisis. And so we’re inclined to think the economy gets to keep growing, but probably at a slower rate as it absorbs that extra challenge as well.

And I guess beyond that, I can say that we’re also seeing some evidence of a reluctance to spend—at least for big-ticket items—from consumers. A survey of, is it a good time to make a major purchase, is actually at the lowest level in 40 plus years in the U.S. right now.

Now, there may be benign explanations in the sense that maybe people are just shifting from all the goods they bought the last two years to services and so they’re not going to buy big-ticket items. That’s an option. They could still spend. It could simply reflect that it’s still hard to get things and so it’s not a good time to buy because it’s hard to get a car, as an example. And so that will resolve as supply chain problems are fixed. And people would still like to spend, they just can’t.

However, there may also be more malignant explanations. And so it could reflect the fact that prices are now unaffordable in some cases. Or it could reflect buying fatigue after lots of spending over the last few years. It could reflect rising borrowing costs. And of course, there’s been just a general sense of trepidation around high inflation.

And so maybe the takeaway here is, we still think consumer spending can be pretty decent for 2022. In fact, it has been good, even as consumers have expressed the trepidation so far. Nevertheless, consumer spending growth very unlikely to be as enthusiastic as it was last year, as an example.

Okay. Let’s spend a moment on central banks. And so, in North America, both the U.S. Federal Reserve, the Bank of Canada, have increased their policy rate now. They’ve begun their tightening journey. It was a 25 basis-point increase for both in March. And certainly, expectations have been set for significantly more. In fact, recent comments have suggested that there could well be a 50 basis-point rate increase for both central banks at the next opportunity. There’s been lots of talk about moving more aggressively and acting forcefully and these sorts of things. And that’s maybe code for a 50 basis-point rate hike at the next opportunity.

In the U.S., the Fed is itself predicting a nearly 2% policy rate by the end of this year, which is a big jump from essentially zero at the start of this year. I can say that, when we look at the outlook for the next year, certainly it seems one should brace for fairly aggressive tightening in the near term. We think maybe the tightening won’t be quite as much, though, as the market thinks a little later out. We just keep thinking in the second half of the year, growth is probably slowing, inflation is probably becoming a little bit less high, central banks may not need to fight quite so hard. Right now, they’re very much trying to establish their inflation-fighting credentials. If they can establish those, it may not be necessary to actually raise rates as much as they’re saying right now.

And let’s finish on just recession risk thoughts. So there’s been a lot of talk that the 2-year/10-year spread—the difference in interest rates between those two spots on the curve in the U.S.—is not far from inverting. And often when that inverts, you get a recession. In fact, almost always.

However, we would emphasize a few things that suggest recession risk, while high, is not at all a certainty.

And so, one would be we haven’t seen that curve invert. So that’s the starting point. But in addition, there are other arguably better measures on the yield curve that tell us about the risk of recession, like the 3-month to 10-year spread. It’s actually held steady; like another very short-term measure looking at 3-month T-Bills forward 6 quarters. That’s actually steepened, suggesting a falling risk. The inflation-adjusted yield curve hasn’t flattened at all. I guess the point would be we have one indicator saying the recession risk has gone up a lot; we have three or four others that are suggesting it maybe hasn’t. So keep that very much in mind.

And so, we would say the risk of recession is elevated. We’ve been saying the risk of recession in the U.S. and Canada over the next year may be a little north of 25%, which is significant. For Europe, maybe it’s not that much shy of 50%. But nevertheless, the base case scenario is still one of a recovery that persists and is more likely than not. But maybe it’s not a time for aggressive investment risk-taking at this juncture.

Okay. I’ll stop there and say thanks very much as always for your time. I hope you found this useful and interesting. And talk to you again next time.



For more information, read this week's #MacroMemo.

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Publication date: March 29, 2022

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